Trading the HUI/Gold Ratio

With gold pushing shiny new 16-year highs this week, contrarian investors
and speculators continue to earn dazzling profits in this young
bull market. But even though gold's mainstream notoriety continues to gradually
increase during exciting weeks like these, it remains a very small sector in
the grand scheme of the markets.

As I discussed a
couple weeks ago, actively trading an up-and-coming sector can be quite challenging.
Young bull markets in traditionally overlooked sectors lack the amazing array
of highly specialized trading indicators which the mainstream stock markets
take for granted. As such, contrarians are constantly striving to create innovative
tools to aid their trading decisions.

In response to my thoughts on designing custom HUI-specific indicators carefully
tailored for today's gold-stock bull, I have been blessed with some fantastic
feedback. I am very grateful as generous speculators, investors, and analysts
from around the world have shared some outstanding ideas with me. I have learned
a great deal so far thanks to these people graciously helping me expand my
perspectives on trading indicators.

One gentleman sent me a neat idea last weekend that led to this essay. He
developed an innovative and elegant way to cull crystal-clear major intermediate
trading signals out of analyzing the ongoing relationship between the HUI and
gold. This really caught my attention since ratio
analysis is becoming increasingly popular among contrarians these days.

A ratio, which in market terms is one price series divided by another, provides
an excellent way to precisely quantify the relative performance between two
different market prices. When a ratio is created with price A as the numerator
and price B as the denominator, the interrelationship between A and B is far
easier to understand. The single A/B ratio graph is vastly more intuitive and
easier to assimilate than the challenging exercise of trying to mentally combine
two separate graphs of A and B to understand their relationship.

With this A/B ratio example, if A is outperforming B the ratio will rise.
But if A is lagging B, the ratio will fall. Thus the ratio distills and illustrates
the relative performance differences over time between two separate price series.
Ratios can reveal subtle trends in relationships that are difficult to detect
when comparing two conventional price charts.

The popularity of ratio analysis has exploded in the past five years or so.
I suspect a key factor in this development is the emergence of powerful websites
like www.StockCharts.com that enable
traders to instantly and effortlessly create any kind of ratio they wish. By
entering any two financial symbols in StockCharts.com separated by a colon,
new ratios can be created as fast as one can think them up.

One particular ratio that has long intrigued contrarians is the ratio of gold
stocks to gold itself. During any major bull market in gold, there are times
when gold stocks radically outperform gold during uplegs. Naturally these are
the very times when investors and speculators want to be heavily long gold
stocks. Conversely, there are also inevitably times when gold outperforms the
gold stocks. While this can be due to gold rising faster than stocks, more
often than not it is the result of gold stocks correcting far faster
than gold. These are not good times to be long.

Since today's premier unhedged gold-stock index is the HUI, the gold-stock-to-gold
ratio of choice today is the HUI/gold ratio. This is easy to pull up at StockCharts
by typing in the symbol $HUI:$GOLD .
While this ratio is discussed and debated almost constantly on Internet gold
forums, I hadn't yet seen a comprehensive and elegant way to trade it for major
intermediate trends until last weekend.

My friend and fellow analyst/financial commentator, Matthew Frailey, graciously
shared a simple and brilliant approach to trading the HUI/gold ratio with me.
Mr. Frailey runs www.BreakPointTrades.net where
he shares comprehensive technical analysis and speculation signals with his
subscribers. He publishes a weekly newsletter covering many sectors including
gold as well as periodically contributes essays to gold portals. In addition,
as a technician's technician he is an adept chartist ranked high in the StockCharts.com Hall
of Fame. If you love charts as much as I do, you owe it to yourself to
check out his website.

While pondering how to help his clients ride the same major intermediate trends
in gold stocks that we chase, Mr. Frailey pointed out the following to me. "Rather
than analyzing a chart of the HUI, I think a ratio between the HUI and gold
metal is far more useful. Gold stocks tend to outperform or underperform gold
metal at various times. Obviously, it is the times when gold stocks outperform
the metal when you want to own gold stocks."

In order to discern these times when gold stocks are due to outperform gold
in a major upleg, Mr. Frailey developed a great system that parses the undulating
HUI/gold ratio to ferret out key buy and sell signals to ride major intermediate
trends. By deftly combining linear resistance breakouts with 50-day moving
average failures, his system throws out very clear signals that are unambiguous
and easy to interpret. As an added bonus, these signals are easy to watch for
in the future on a StockCharts.com $HUI:$GOLD ratio
chart.

Our three charts below detail this trading system, beginning with a bull-to-date
HUI/gold ratio strategic view to outline the general thesis. After this, we
zoom into the latest major upleg and correction in gold stocks in additional
graphs to observe how the most recent HUI/gold ratio trading signals unfolded
on a tactical level.

Before we delve into how to trade it, the HUI/gold ratio itself is quite interesting.
Notice above how this ratio systematically marches higher during our current
secular bull market in gold and gold stocks. Powerful uplegs unfold as the
HUI outperforms gold stocks. After these uplegs when the HUI and gold inevitably
correct to take a healthy breather though, the ratio tends to consolidate,
either grinding sideways or retreating. If you compare this ratio graph with
a conventional HUI-only
graph, of course the ratio uplegs precisely match the HUI uplegs' timing.

Now since this ratio reveals the relative performance of the HUI compared
to gold, it offers deeper clarity in some senses than a HUI chart alone. While
a HUI-only chart shows an effect, gold stocks leveraging a gold bull, this
ratio chart illustrates the relationship between the cause (gold bull) and
effect (gold-stock bull). This ends up filtering out some of the incessant
noise that plagues HUI charts.

For example, during every major post-upleg consolidation to date, late 2001,
late 2002, and late 2003, the HUI appeared to carve double tops which spooked
some players. Double tops tend to be bearish, since the standard interpretation
is that a price is hitting major bull-to-date resistance for a second time
but remains woefully unable to punch through.

In the ratio chart shown above though, the HUI interim highs of mid-2001,
mid-2002, and late 2003 are very unambiguous. The ratio topped and headed lower
into the necessary correction without any technical lollygagging. No ratio double
tops formed. Many intriguing comparisons like these become evident if you compare
a HUI/gold ratio graph to a HUI-only graph. The ratio expressing the cause
and effect as one seems to act as a filter to helpfully moderate the high noise
levels inherent in the pure HUI data.

Matthew Frailey's elegant HUI/gold ratio trading system is drawn in above.
A combination of the blue top resistance lines during consolidations and the
white 50-day moving average during uplegs is used to define major buy and sell
signals. If you look at the actual green and red buy and sell signals drawn
on this chart, it is readily apparent that buy signals flash right as major
uplegs launch while sell signals sound soon after these uplegs top. This system's
timing for gaming intermediate gold-stock trends is quite good.

In order to define a HUI/gold ratio buy signal, the ratio must first decisively
break out above its latest consolidation's upper resistance line. In
the past four years there have been three major consolidations with three resistance
lines, all drawn above in blue. These resistance lines connect the latest bull-to-date
ratio high with the inevitable subsequent descending highs as gold stocks correct
after a major upleg.

For months after a major interim top, the HUI/gold ratio struggles but continues
to fail near the consolidation resistance. But, eventually, sooner or later
sentiment waxes too negative so a major new upleg is due to erupt. The actual
advent of this upleg, and the end of the preceding correction, is announced
when the ratio finally musters the strength to blast up through and shatter
the consolidation resistance lines.

Such buy signals flashed in early 2002 and mid-2003 right on the door step
of the two most powerful gold-stock uplegs in this bull to date. Investors
and speculators alike would have done very well to throw long quality unhedged
gold stocks as these buy signals triggered. Incidentally, the latest buy signal
just flashed in August and suggests we are already in the early months of the
next major gold-stock upleg today.

Mr. Frailey defines sell signals as times in major uplegs where the HUI/gold
ratio collapses back down below its 50-day moving average. During the
uplegs the ratio's 50dma tends to act as strong support until the upleg
reaches maturity. But once a major upleg crests, soon after the event its 50dma
fails as support. It is these very moments when the HUI/gold ratio decisively
pierces through its 50dma to the downside when speculators should consider
selling their gold stocks to ride out the coming correction.

Three of these HUI/gold ratio sell signals are drawn in the graph above, each
of which occurred after one of the major bull-to-date uplegs in the HUI. Any
speculator who heeded these signals could have avoided 80% or so of the subsequent
corrections following the major uplegs. Naturally this would put speculators
way ahead in the capital game, since they could ride the uplegs but then deftly
pull out their capital early in the corrections so they don't suffer serious
losses. Then this prudently preserved capital can be plowed right back in when
the next buy signal triggers.

So a HUI/gold ratio buy signal is triggered whenever the ratio decisively
breaks out from a descending resistance line during a consolidation/correction.
The subsequent sell signal then triggers when the ratio's 50dma fails as primary
support following a major upleg. Definitely simple, yet elegant and very effective
so far in this gold bull to date!

Now that you have seen the big strategic picture, these signals become even
more clear when considered from a tactical perspective. In order to illustrate
this, we zoomed in to consider last year's massive upleg to show a buy signal
and this year's ugly correction to highlight a sell signal. The blue dashed
squares in the strategic chart above show the zoomed in areas from which our
next two tactical charts have sprung.

Calendar 2003 was a phenomenal year for contrarians invested in gold stocks,
and this ratio certainly shows it. Between March and early December, the HUI
took off and vastly outperformed gold. This period of relative strength does
a fantastic job of illustrating how to combine HUI/gold ratio buy and sell
signals to ride a major upleg in gold stocks.

The whole process begins during a consolidation following the last major upleg.
During this time gold stocks, since they are leveraged paper, tend to fall
farther and faster than gold. The relative underperformance of the gold stocks
creates a downtrend in the HUI/gold ratio. This ratio grinds lower within the
confines of this trend, periodically rallying but usually failing to break
back above its descending resistance line. Until the ratio resistance breakout
actually occurs, investors and speculators can bide their time while the correction
fully runs its course.

In March 2003 gold stocks bottomed as Washington prepared to invade Iraq.
The HUI/gold ratio started trending higher from that point but didn't break
out until the beginning of June. While the HUI did rise between March and June,
one thing I really like about this particular trading tool is it demands conservatism.
Trying to catch falling knives, picking the exact HUI bottom, can be hazardous.
Speculators can use other
tools to attempt this if they wish, but investors don't need to trouble
themselves with this exercise.

By patiently waiting for the HUI/gold ratio buy signal of the resistance breakout,
investors increase their probabilities dramatically that they are not buying
in until a major new upleg is already underway. Most of the false buy
signals are weeded out waiting for the breakout so the gains should accrue
fairly steadily if a buy is made once the signal is flashed. It probably won't
deliver an entire upleg into your lap, but the ratio will certainly alert you
to the strongest 80% of one!

After throwing long gold stocks at the buy signal, all investors have to do
is watch the HUI/gold ratio relative to its major 50dma support. As shown in
white above, the ratio tends to bounce at its 50dma during all minor pullbacks until the
HUI upleg has reached maturity. Shortly after the intermediate top, the 50dma
fails as the ratio plunges down through this support line. Once the 50dma is
decisively broken, it is time to sell and wait for the next HUI/gold ratio
buy signal.

Now this sell signal will not be triggered at an exact top either, but this
too is a very conservative approach. By waiting until the 50dma is decisively
pierced, investors vastly decrease their odds of being whipsawed out early
by a minor pullback within an ongoing upleg. Instead, a true 50dma support
failure probably won't transpire until a major correction is already underway.
This sell signal helps investors and speculators stay in as long as possible
during a major upleg, but then gets them out while a major correction remains
young and mild. Avoiding 80% of major corrections is a great way to multiply
capital!

On a tactical level these signals are as easy to understand and apply as they
sound. Buy on a ratio resistance breakout during a consolidation and sell on
a ratio 50dma failure after a major upleg. Our final graph, covering October
2003 to September 2004, shows how well this elegant system works during major
corrections.

After topping in late 2003, the HUI entered a brutal correction in early 2004.
The HUI/gold ratio declined because gold outperformed the HUI in the initial
months of this correction and then gold sunk far less rapidly than the HUI
in the correction's late capitulation stages last spring. This traumatic event
is recent enough to remain seared in the memories of contrarians, so it is
perfect to illustrate the HUI/gold ratio signals during a major correction.

After a major interim top is carved, at some point in the subsequent weeks
or months the HUI/gold ratio's 50dma fails as support. This failure, which
happened in December 2003, acts as a sell signal to warn speculators of an
impending correction. In this latest example, the HUI was trading near 240
when this alarm signaled but only 170 at its May bottom, so heeding the sell
in December would have saved speculators 29% in additional losses, not bad
at all!

After the 50dma-failure sell signal triggers, the ratio starts grinding lower
in general although this decline is punctuated with periodic relief rallies.
After a couple of these relief rallies are burned into the charts, traders
can start plotting a ratio resistance line like the one shown above. As this
line is gradually defined over the correction months, it creates a reference
point from which traders can watch for the first decisive breakout.

As long as this resistance line holds, no buy signal is triggered and odds
are the HUI remains in consolidation/correction mode. As you can see above,
the resistance tends to repel the periodic ratio advances and keeps the downtrend
intact. But once a decisive breakout occurs, as in August 2004, then a buy
signal is triggered and it is time to throw long again in anticipation of a
major new gold-stock upleg.

Once again the conservative nature of this indicator really shines through.
Using relativity tools,
I went long our current upleg in April and
May, which really was the interim bottom. Yet, even though the absolute bottom
was indeed in May, the HUI still sputtered along and consolidated for several
more months. This summer, which was psychologically grating for gold-stock
investors and speculators, could have been avoided all together with this ratio
indicator.

Conservatively this ratio breakout didn't occur until August, after the entire
consolidation had fully run its course. While its buy signal wasn't
triggered at the exact bottom near HUI 170, it did trigger around HUI 185 in
August and therefore would have saved folks from enduring this summer's long
demoralizing sideways grind. Once again, especially for risk-averse investors,
it pays to err on the side of caution and wait until a new upleg is already
underway rather than trying to catch falling knives.

The bottom line is Matthew Frailey's simple and elegant technical system to
wring clear buy and sell signals out of the HUI/gold ratio is an excellent
addition to any investor's or speculator's trading toolbox. Whether you use
it as a conservative primary indicator as an investor or a secondary confirmation
indicator as a speculator, it helps filter out the HUI noise to identify major
intermediate trend changes early.

I am looking forward to observing this indicator myself as this awesome gold
and gold-stock bull continues to unfold in the future. We will use it at Zeal
to illuminate the HUI from a different perspective and provide confirmation
for our other technical tools. It ought to help us continue to recommend superior
gold stock and gold-stock options trades for our newsletter subscribers.

The better we can use technicals to illuminate the prevailing trends, the
higher the probability we can detect major tradable trend changes early when
they are still highly profitable to trade. As Mr. Frailey pointed out to me,
the best time to own gold stocks is when they are due to far outperform gold
in a major upleg.

Since the HUI/gold ratio quantifies the relative performance of gold stocks
to gold, it provides vital clues of newly developing intermediate trends not
readily evident in the HUI alone. And this neat HUI/gold ratio technical trading
system defines simple rules to help capitalize on these new trends while they
still remain young and promising.

If you have questions I would be more than happy to address
them through my private consulting business. Please visit www.zealllc.com/financial.htm for
more information.

Thoughts, comments, flames, letter-bombs? Fire away at zelotes@zealllc.com.
Due to my staggering and perpetually increasing e-mail load, I regret that
I am not able to respond to comments personally. I WILL read all messages though,
and really appreciate your feedback!

Mr. Hamilton, a private investor and contrarian analyst,
publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis
of markets, geopolitics, economics, finance, and investing delivered from an
explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for
more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to
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